Is Divestment from Fossil Fuels a Sound Financial Play?

In the 1980s, investors played an important role in helping to end apartheid in South Africa by divesting their investments in companies doing business in that country. Today, a similar strategy is being employed to counteract climate change. Pension funds, endowments and individuals are being asked to go “fossil fuel-free” and sell off any company stock in the oil, natural gas, and coal industries.

While few institutions have so far enacted a divestment strategy, more than 300 college campuses, a growing number of cities and one state are considering going down this path. According to Charles Derber, who was one of my favorite graduate school professors at Boston College, the argument for action is clear. “The two patron saints of universities are values and science, and both are telling us climate change is the biggest problem we face.”

I am certainly not here to discuss values and science, as I think the arguments for action on global warming are clear on both cases. That said, arguments for taking action against the abomination of apartheid were also clear, yet there was always one roadblock that kept investors from taking action on South African divestment: economics.

When I first began working in the field of socially responsible investing in 1982, one of my first tasks was to work on studies that examined whether divestment from companies doing business in South Africa could be done in a responsible way. This was no small job. At that time, nearly 40 percent of the market value of the S&P 500 index was made up of companies who had operations in South Africa. Asking colleges and pension funds to eliminate most major companies and entire industries seemed wrong on investment terms.

Yet what we found in our studies was that portfolios of companies without operations in South Africa outperformed the S&P 500. That was the message we took to Washington, D.C., Nebraska, Missouri and other states and colleges across the country. The fossil fuel-free movement should focus on a similar message today, but hasn’t so far.

In recent hearings, Massachusetts debated whether to become the first state in the country to go fossil fuel-free. State Senator Benjamin Downing argued, “At some point, those fossil fuel companies will not be a good investment.”

With all due respect Senator Downing, that day came and went about five years ago.

For the past five years, the stocks of fossil fuel companies have underperformed the S&P 500, and this underperformance has been accelerating in recent years. For the five years ending on September 23, 2013, the energy stock component of the S&P 500 has increased by 5.71 percent on an annualized basis versus a gain of 9.87 percent for the entire S&P 500. For the past one year, energy stocks rose by 11.79 percent versus a 19.17 percent increase for the S&P 500.

Why has this occurred? Interestingly, many of the same factors that are causing energy stocks to underperform—peak demand and technology—are the same elements that allowed South Africa-free portfolios to thrive.

Rising oil prices had the same impact on the economy in the 1970s that they have had over the past five years. While many people still argue that our demand for energy never goes down, it does, in fact, respond fairly predictably to changing prices. Following a surge in oil prices in 1979, the United States’ usage of oil did not surpass this level for 18 years. Europe has yet to use more oil than it did in 1979.

Quite similarly, U.S. demand for oil has fallen since 2007. Over the past five years, our consumption of oil has dropped by 10 percent. Not only are we driving fewer miles (-2.4 percent), but the fuel efficiency of new vehicles has risen by 22 percent. Does this sound familiar? It should: it is exactly what happened during the 1980s. During that decade, fuel efficiency grew by 15 percent and miles driven fell by -3.2 percent from peak to trough.

While technology has improved cars’ fuel efficiency, it has also led to new growth in supplies. High prices in the late 1970s led to new oil discoveries in the early to mid-1980s as the following chart shows. The increase in new oil supplies (as well as gas, solar and wind) in the past five years dwarves what we saw in the 1980s, however.

In short, we have as a nation – indeed, as a planet – experienced peak demand for oil. Even if supply begins to wane, our consumption is on a steady downward trend. The politics of fossil fuel-free investments are well-founded; in the current environment, the economics have a strong foundation as well. Pensions or endowments that do divest from fossil fuel companies are pursuing a wise course of investment in terms of the planet’s health and their financial performance.

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I have been invested in ChinaBak for many years as a way to benefit from the world decreasing its use of fossil fuels and using electric cars instead.

Ryan Miller

This article has one very serious logical flaw: there’s no situation where a forced divestiture from all fossil fuel stocks (in this case the 200 companies with a direct involvement in fossil fuels as specified by 350.org) will benefit the entities holding those investments. Yes, it’s very possible that fossil fuel stocks will continue underperforming market aggregates and it’s very possible that investments in other areas will provide a better return. However, there is nothing preventing investment and hedge fund managers from moving away from fossil fuel stocks right now.

Without a screen for fossil fuel stocks, a manager may still move away from those stocks if they find they can have a better return in other areas. It may be that the optimal portfolio has no fossil fuel investments. However, that case (where the best portfolio has no fossil fuel stocks) can be achieved with or without a forced divestiture. There’s no situation where a investor not screening for fossil fuel stocks will have a lower possible return than an investor that is screening. In any situation where the best possible portfolio can be achieved with some amount of investment in fossil fuels, no matter how small, the manager that divests from fossil fuels will underperform the optimal portfolio. This is the basic logic behind the phrase “more options are better.” A larger possible set of options will always be better because it contains the entire smaller set of options within it.

That isn’t to say divestment isn’t a good idea. It’s just to say that this argument for forced total divestment (that it makes economic sense for the investor) is invalid.

chunkylover

Hey Ryan, Best of luck in Sochi. The Buffalo Sabres kinda stink this year. Rest up for the Olympics. Do you think you will beat Quick for the spot? Fossil fuels are like Team Canada… yesterday’s news

Jonathan Quick

Yeah, right. Let’s see if he can win a game in the NHL this season before you go and hand him the USA starting job.

Bobby Luongo

Whatever Chunky, Team Canada is yesterday’s news? Who is the current gold medal champion? Good luck to Ryan Miller and Quick. You guys are gonna need it. Also, I’d be interested to see figures regarding fossil fuel consumption in emerging markets versus the developed world. China is giving huge subsidies to the solar industry, but I fear it may not be enough to offset the country’s growing thirst for oil.

Patrick McVeigh

Over each of the past three years, total worldwide demand for oil has grown at less than 1 million barrels per day. U.S production alone is up over 1.2 million barrels per day in the past year. Ignoring what is going on production-wise in the rest of the world, growth in U.S. production alone is enough to satisfy worldwide growth.

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